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How currency-hedged ETFs eliminate foreign exchange risk

There is growing interest among the index fund investment community in currency-hedged ETFs, and for good reason. As we've written elsewhere in this series, they offer investors the benefits of global diversification without the risk of adverse currency movements. But how do they work?

To understand that, consider the situation in a non-hedged world. A British-based investor who wants to buy US stocks must first sell the requisite amount of sterling and convert it to US dollars. If in a year the investor sells, the investor must convert the dollars received as payment sterling. If in the meantime the pound has lost value against the greenback, the investment return will be effectively reduced. In a volatile currency market, this could potentially turn a winning investment into a loss.

The classic hedge

In the classic currency hedge, along with converting the sterling to dollars to make the purchase, the investor borrows the equivalent amount in dollars and converts it to sterling. When the dollar investment is sold the investor reconverts the borrowed dollars.

Any gain or loss in the investment due to currency movements are negated by the equal but opposite movement of the hedge transaction. The investor receives the pure performance of the investment, good or bad – sidestepping the influence of currency markets altogether.

Of course, with a hedge the investor also does not receive the benefits of favorable foreign exchange movements. In today's volatile environment, timing currency markets is particularly difficult. For international investors focused solely on the potential benefits of their investments solely, a currency hedge is a powerful tool.

Easier said than done

While hedging is easy in theory, in practice it can be quite cumbersome, especially in portfolios with multiple currencies or large numbers of transactions.

Luckily, index investors today have a simple alternative. With the advent of currency-hedged ETFs they can now buy indices with the currency hedge already baked in. This allows them to buy foreign securities as if they were denominated in their home currency, without having to think about the complexities of the actual hedging transactions.

All the investor need do is decide on the desired asset class and region, and find a matching fund. The currency – with all its inherent pitfalls – is not an issue.

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